the requirement for flexibility in capital budgeting
TRANSCRIPT
Microsoft Word - BScThesis_AdaAadeli.docxThe requirement for
flexibility in capital budgeting
Author Ada Aadeli Title of thesis The requirement for flexibility in capital budgeting Degree Bachelor’s degree Degree programme Accounting Thesis advisor(s) David Derichs Year of approval 2016 Number of pages 33 Language English
Abstract of bachelor’s thesis
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1.2 PREVIOUS WORKS 8
3. FLEXIBILITY ANALYSIS IN CAPITAL BUDGETING 11
3.1 FORMS OF FLEXIBILITY 11
3.1.1 CHOICE OF TIMING 12
3.1.2 OPTION TO EXPAND OR CONTRACT 13
3.1.3 TEMPORARY SHUTDOWN 14
3.1.5 FLEXIBILITY OF VALUE CHAIN 15
3.1.6 VOLUME FLEXIBILITY 15
3.1.7 GROWTH POSSIBILITIES 16
3.2.1 SENSITIVITY ANALYSIS 17
3.2.3 WEIGHTED AVERAGE DISCOUNT RATE 18
3.2.4 APPLICATIONS TO THE NPV METHOD 18
3.3 CHALLENGES TO FLEXIBILITY 19
3.3.1 ADDED EXPENSES 20
3.3.3 INTEGRATION TO CORPORATE STRATEGY 21
3.3.4 ECONOMIES OF SCALE 21
3.3.5 BALANCING CONTINUITY WITH FLEXIBILITY 21
4. EFFECT OF INTEREST RATE FLUCTUATIONS 22
5. CONCLUSIONS 26
6. REFERENCES 28
7. APPENDIXES 30
1. Introduction
In the current state of our world economy, boosting investments has long been viewed
as an effective fixing method. By encouraging further capital commitments in order to
create more available jobs and overall economic growth, increased investments are a
positive development. Interest rate targeting by central banks is a way for monetary
policy to encourage more investment through affordable loan capital (Roche et. al,
2015). However, at this point in time interest rates are at a record low and the
environment is ever more turbulent. Globalisation and the fast development of
information technology have resulted to shorter product life cycles, constantly changing
consumer preferences and increasingly aggressive competition (Dreyer and Grønhaug,
2004).
Capital budgeting is a key function to evaluate investment profitability. The information
provided by these calculations is then used as a basis for capital outlay decisions. The
most common methods used in capital budgeting by US firms are the net present value
(NPV) and internal rate of return (IRR) methods (Graham and Harvey, 2002). Both of
these use a set hurdle rate, the weighted average cost of capital (WACC) in calculations
and as a comparison to aid decision-making. The WACC is determined by utilising the
risk-free rate, and is thus prone to distortion effects caused by the current zero-bound
level interest rates in place. If we move on to the European markets, where the most
common technique is the payback period (PB) method (Brounen et al. 2004), the
interest rate level comes into play again through the discounted cashflows. The unusual
state of the world economy affects decisions made by accounting departments, causing
distortion due to false market effects (Roche et al. 2015). Traditional methods rely
heavily on the WACC, which can easily be wrongly evaluated. If interest rate levels
elevate unexpectedly, calculations may become invalid. However, as rates are expected
to remain relatively low for some time still, shorter-term capital allocation projects are
less prone to fluctuations in rate levels. Also, short-term cashflows can be forecasted
more reliably. The situation is different in longer-term projects. As the time horizon of a
project grows so does the uncertainty regarding its outcomes. Due especially to these
recent developments, an increased level of flexibility in long-term investments is
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desirable. To better understand the benefits of flexibility is therefore crucial to sustain
competitive advantage.
This analysis focuses solely on illiquid investments made by private sector actors, such
as production facilities or machinery. To define what is meant by flexibility, it is the
range of options that the investment itself contains. It is not a one-sided concept, as it
entails multiple options. At its simplest, it can be defined as flexibility in the breadth of
capacity, operation level, production outputs, volume and timing (Dixit and Pindyck,
1994; Dreyer and Grønhaug, 2004). In long-term decision-making investments are
vulnerable to changes and it might be desirable to be able to defer investment, alter the
focus or even modify the overall direction or timing of a given project. Investments may
have an abandonment option or possibilities for alteration in e.g. production facilities
(Dixit and Pindyck, 1994). Also, real options, which are new project possibilities
obtained by making the initial investment, are considered as a part of flexibility as they
give room for modifications to the initial investment plan, should conditions change.
Solely pushing for more investments without considering the effects and risks brought
on by a longer time horizon is an ignorant move. It should be kept in mind that
conditions might and will change in the scope of the investment period, as it grows to
several decades. Markets are volatile and forecasting models always imperfect. Interest
rates are traditionally considered to be more stable than revenues, which is why they
are viewed as a constant in calculations, mostly focusing on altering cash flow scenarios
(Alvarez and Koskela, 2006). In the current state of the world, this assumption is no
longer valid in the long run. As a clarification, the cause of current interest rate levels
The factor of uncertainty in investment decisions is often disregarded (Chittenden and
Derregia, 2015). The risk profile of long-term investments is generally higher than that
of the short term, as the determination of cash flow forecasts becomes more difficult
(Cornell, 1999). However, firms usually still only set a single hurdle rate to evaluate all
investments, regardless of the time horizon. A survey in the Nordic countries discovered
that 85,6% per cent of firms responded that their hurdle rates don’t increase with the
time scope of the investment. What is even more alarming is that some even used a
lower rate for the longer term (Brunzell et al. 2013). These implications show that firms
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are not at the moment fully aware of the requirements brought on by the increased
uncertainty in our investment environment. Practise does not comply with general
financial theory, suggesting that the longer span of future cash flows requires higher
hurdle rates, as they are more uncertain (Mukherjee, 1991).
If we move on to the execution of the actual requirement, flexibility, room for
improvement definitely exists. In order for firms to better maintain their market
positioning and even exist in today’s highly competitive business environment, they
must acquire heightened levels of flexibility. This aids them to weather the movements
of the turbulent environment (Dreyer and Grønhaug, 2004). Valuation of flexibility and
real options obtained is complex, as it includes multiple levels and time horizons.
However, it is now more important than ever for firms to focus their capital assets on
investments with strong potential in order to ensure future success. Often the valuation
models developed in order to count flexibility into calculations are not put to use due to
their complicated and multi-level nature (Smit and Trigeorgis, 2006). This leads to
misevaluation, as the true value of flexibility is not included, further leading to
misevaluations and faulty decision-making in capital budgeting (Feinstein and Lander,
2002).
This thesis aims to pinpoint the need for added flexibility and the reasoning behind it.
Short-sighted, traditional decision-making processes lack the ability to exhaust all
possible options, making them inadequate to fit the current environment. The
motivation behind this paper is to further demonstrate the importance of flexibility
options, the benefits derived from their adoption into capital budgeting and to critically
evaluate the presented methods of valuation. In order to achieve this, the paper will
assess the validity of three key propositions:
1. Capital budgeting methods need to incorporate flexibility in order to correctly
value investment opportunities
2. Flexibility must be established in a versatile manner to shield the firm from
future fluctuations
3. Currently interest rate levels are key external factors calling for greater flexibility
in capital budgeting
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The following analysis aims to provide insight and prove these propositions right with
1.1 Methods and structure
The analysis has been conducted based on a review of the appropriate literature. To
complete the work and to further present the vast effects of not accounting for
flexibility, a few simple examples using traditional capital budgeting methods by varying
interest rate levels have also been included. As the issue of capital budgeting has been
widely researched in the past, all necessary information can be collected from the right
sample of works. It is not within the scope of this thesis to conduct further research. By
then combining this available theoretical information and previous empirical research
into a comprehensive unity, the value of flexibility can be demonstrated and valuation
methods can be critically assessed. The key terms used in the literature search were
flexibility, real options, flexibility valuation and interest rates, all within the context of
capital budgeting. Using the title and abstract as pruning factors, the sample literature
was chosen from the returned search results. The literature review was conducted by
utilising a Boolean phrase search in Aalto Finna database and Google Scholar. The main
base for the flexibility analysis section was Dixit and Pindyck’s (1994) “Investments
under Uncertainty”. From this book the view on versatile flexibility options and the
limitations they might face was expanded into further material, by identifying key
search terms and utilising the appropriate original sources. Literature on flexibility
measures in capital budgeting can concern both liquid and illiquid investment
opportunities. Some theories and forms however apply to both, in which case they are
presented here only in the context of illiquid investments.
Using a simple model to prove real effects is in itself perhaps obvious, but still necessary.
The capital budgeting methods currently utilised by most private sector actors no longer
capture the true values of investment projects. By making small alterations we can
demonstrate the importance of accounting for flexibility in calculations.
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Structurally the analysis will start at the very core of capital budgeting; the traditional
methods that have been in place for several decades. Establishing the shortcomings and
oversights of the discounted cash flow methods gives weight to the need for flexibility.
Then moving on to flexibility analysis in capital budgeting practises; looking into the
limitations in place and exploring various forms of flexibility. The assessment of
different valuation methods will take place in the context of these background
influencers presented. Finally, bringing in an external factor, interest rates, will further
demonstrate the imminent requirement for flexibility that is accelerated by the current
economic state of the world. As stated before, the analysis will focus solely on the effects
regarding the increased requirement for flexibility, not to take a stance on what is
causing the current interest rate environment.
1.2 Previous works
Identifying the current status quo in capital budgeting is crucial before conducting new
analysis. Though flexibility is often thought of as a relatively new concept in capital
budgeting, multiple studies and theories have existed for several decades. The valuation
and consideration of real options has been brought forward in addition to the traditional
methods, such as NPV, IRR and PB (e.g. McDonald and Siegel, 1985; Dixit and Pindyck,
1994; Dreyer and Grønhaug, 2004). The effect of certain environmental factors, such as
developments in consumer demand and changes in interest rate levels, has also been
previously connected to capital budgeting (e.g. Dixit and Pindyck, 1994; Kulatilaka and
Trigeorgis, 2001; Alvarez and Koskela, 2006).
Shortcomings of traditional methods have been widely recognised, but for some reason
these realisations have not had a dramatic effect on their popularity (Trigeorgis, 1996;
Feinstein and Lander, 2002; Smit and Trigeorgis, 2006). Regardless of the vast extent of
the conversation regarding flexibility, it’s valuation and inclusion in calculations is still
viewed as somewhat of a special feature rather than a solid standard due to the complex
nature of valuation models (e.g. Lander and Pinches, 1998; Feinstein and Lander, 2002).
With these previous presentations in mind, this thesis will bring theories together in
order to prove the benefits derived from adopting flexible practises into capital
budgeting. These statements made by previous literature will be further assessed and
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utilised as a backbone for the justification and purpose of this paper. First, we discuss
2. Pitfalls of traditional methods
Traditional methods of capital budgeting don’t succeed in considering all possible
outcomes as the project begins to unravel (Denison, 2009). Leaving flexibility out of the
calculations may cause management to make serious mistakes in capital budgeting and
bypass projects with the highest real potential (Feinstein and Lander, 2002). The use of
simple discounted cash flow (DCF) analysis leaves out the value of waiting and revising
the investment opportunity as uncertain future outcomes are realised (Lander and
Pinches, 1998). Some basic flaws present themselves in the use of DCF methods. Not
acknowledging time as a risk measure and relying too blindly on a set hurdle rate leave
investments vulnerable to unfavourable environmental changes. Also, by assuming a
constant capital structure and passive management these methods undermine the role
of managers and their reaction capabilities. Most importantly, growth possibilities,
which are significant sources of competitive advantage, are often overlooked with
traditional methods. Next, these underlying weaknesses of traditional capital budgeting
methods are examined.
Disregarding duration
As the time horizon of an investment grows, the predictability of future cashflows
diminishes. This effect has even more relevance in today’s volatile markets (Smit and
Trigeorgis, 2006). Regarding especially long-term investment projects, the net present
value method overlooks the importance and effect of duration. As the time span grows,
interest rate volatility in the long run becomes relevant. This issue causes the hurdle
rate of initial calculations to be incorrect regarding the later years of project life
(Trigeorgis, 1996).
Assumption of passive management
The simple NPV approach also assumes for management to continue their passive
approach on investments even when circumstances alter (Keswani and Shackleton,
2006). As the initial capital outlay has been made, NPV does not consider the possibility
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of alterations, the use of real options, which will be discussed in detail later when
moving on to the flexibility analysis. These modifications can be e.g. abandonment,
capacity or output changes (Dreyer and Grønhaug, 2004). The assumption of this static
Rigid hurdle rate
Though cashflows might be modified to project dynamic decision-making by
management, the faulty in the NPV method often stems from the rigid use of the
discount rate, the WACC. Flexible design of a project enables it to obtain a lower hurdle
rate since it can better be modified to respond to changes in uncertain factors (Lander
and Feinstein, 2002). These possibilities are overlooked, and the discount rate is not
adjusted accordingly.
Assumption of a constant capital structure
Another pitfall of the traditional methods utilising the set hurdle rate, WACC, in
valuation is that the assumption of a constantly remaining capital structure in a longer
project is highly unrealistic. Firms will shift their relation of debt and equity according
to market movements and affordability (Graham and Harvey, 2002).
Overlooking growth opportunities and competitive advantage indicators
What brings the most dramatic difference between traditional, rigid methods of capital
budgeting and the flexible take of real options, are projects with initial negative net
present values. These projects, though seemingly unattractive, might turn out to be in a
key position for unlocking future growth potential (Trigeorgis, 1996). Overall, as
consumer demands are persistently changing, and at an accelerating pace, maintaining
competitive advantages is even more crucial. For a firm to remain at the top, it must be
able to satisfy these altering needs by providing better services. NPV and other
traditional methods overlook such indicators in projects, like quality enhancement and
response time (Aggarwal et. al, 1991). These are hard to directly quantify and may not
On a more general note, traditional methods are also using the same set WACC for all
projects, thus assuming that the risk level of all projects is similar to the firm’s as a
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whole (Trigeorgis, 1996). Investment opportunities should be valuated uniquely, as
heavy dispersion among projects may exist. A very basic obstacle in traditional capital
budgeting is that the conversion of all benefits derived and costs incurred, generated
cashflows and intangible effects can be simply impossible. Quantifying effects such as
increased brand power or positive firm image and then incorporating them into simple
NPV calculations is not feasible. Also, traditional methods are seen to be best suited for
environments with low levels of uncertainty and risk; this does not exactly correspond
Everything discussed above gives weight to the increased requirement for flexibility in
capital budgeting. New valuation methods for projects can provide more reliable
knowledge, lead a firm to the optimal decision and solve some of the issues faced by
3. Flexibility analysis in capital budgeting
As the very concept of flexibility is harder to comprehend than simple NPV analysis
based on discounted cash flows, flexibility needs to first be defined. When the benefits
and content of flexibility have been identified, the value of these flexibility options needs
to be estimated and quantified. Lastly, some basic limitations apply to the use and
Flexibility as a concept entails many different implications. It can be seen as an option to
choose the timing of each investment freely (Kort et. al, 2010), or as the possibility of
alterations as future circumstances begin to realise (Kulatilaka and Trigeorgis, 2001).
Flexibility can be viewed as company-specific; a resource specialised in the adjustment
and full exploitation of a single actor’s opportunities (Dreyer and Grønhaug, 2001).
Before we arrived at one simple definition by combining alternate sources: flexibility
can be defined as ‘wiggle room’ in the breadth of capacity, operation level, production
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outputs, volume and timing (Dixit and Pindyck, 1994; Dreyer and Grønhaug, 2004). Due
to recent developments in the overall investment environment, flexibility has
experienced a rise in popularity and is now viewed as a way to obtain competitive
advantages over rival companies. Some forms of flexibility can also be area- or industry-
specific, or simply not as important in all fields of business (Dreyer and Grønhaug,
2004). In some fields investing in flexibility might not even be worthwhile. These are
industries with low uncertainty in operations and demand (Kulatilaka and Trigeorgis,
2001). However, the current economic environment has vast effects and touches upon
all industries. It is crucial to not only understand but also value these flexible options
correctly and seize the possibilities they bring in order to maintain competitiveness of
the firm.
These options can either occur naturally or require additional capital outlay (Baldwin
and Clark, 1992). It is crucial for firms to have high-quality knowledge on their
respective operating markets. Evaluating whether to invest in a more expensive but
flexible investment rather than the rigid one with lower initial cost is a fundamental skill
in competitive industries (Feinstein and Lander, 2002). Now, we examine the different
realisations of flexible options in investments presented in different publications. Some
of these forms have been recognised as general flexibility in operations, but as we focus
on illiquid investments, such as manufacturing facilities, the same options and their
3.1.1 Choice of timing
In most investment decisions, timing is crucial. Finding the correct position for new
market entry or construction might make or break a project. Even if a project already
shows positive NPV, it might be more profitable to wait for better conditions or new
available information regarding the market (Kulatilaka and Trigeorgis, 2001). Another
implication of timing derives from the competitive forces at play; early investment and
the risk it bears might be optimal if there is danger of otherwise losing the opportunity
to a competitor (Smit and Trigeorgis, 2006).
The option to defer investment to a later time is indeed a key form of flexibility, though
not always a possibility. Strategic focus or aggressive competition might force a
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company to make quick investment decisions (Dixit and Pindyck, 1994). Generally the
first investor, a pioneer in a sense, collects the largest financial compensation among the
rival group when strategic effects of investing exist. However, when uncertainty levels
are high, early commitment might not be the best option regarding future outcomes. If a
spill-over effect regarding information exists in the field, it might be more beneficial to
be a follower rather than the leader (Chevalier-Roignant et al., 2011). In these situations
second-to-entry firms might actually find cost benefits from lower need for consumer
analysis or R&D projects.
Deferring investment is however, usually achievable. It may incur some added costs,
which include the risk of other market entrants and lost possibilities, but as previously
stated, new market information can be worth the wait. Being able to wait for the
investment opportunity’s true potential to be revealed can salvage the company from
making rash decisions that can turn out to be costly (Dixit and Pindyck, 1994). What
most commonly incentives firms to exercise the possibility of deferring investment are
uncertainty over demand or interest rates and the lack of sufficient internal capital
(Chittenden and Derregia, 2013). The value of waiting is generally higher when interest
rate uncertainty is high and the overall duration of the project is long (Trigeorgis, 1996).
This indication applies perfectly to the capital budgeting decisions discussed within this
paper.
3.1.2 Option to expand or contract operations
When the investment has already been carried out, and operations are functioning at the
initial intended capacity, companies examine the realisation of their projected demand.
If they find that demand is higher than expected, they might consider investing in
further capacity to satisfy this demand. On the contrary, if demand is lower than
projected at initiation, a firm may choose to contract operations in order to save on
variable costs (Kulatilaka and Trigeorgis, 2001). Expanding operations is a partially
irreversible investment; it requires further capital outlay on e.g. manufacturing
hardware. Contracting can however be reversed without significant cost, if it is executed
by leaving facilities idle and not by selling equipment.
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Adding capacity usually has the initial effect of increasing profit margins, as fixed costs
remain the same but there are more units to cover the incurred costs. Eventually the
leap to larger fixed costs must be made and often the situation of diminished returns
comes into play (Dixit and Pindyck, 1994). So, the alterations in demand should be
considered somewhat permanent in order to justify irreversible expanding of
operations.
3.1.3 Temporary shutdown
The basic idea behind a temporary shutdown is simple; as derived revenues are less
than variable costs, operations should be seized. This option however is rarely examined
in the initial process of capital budgeting (McDonald and Siegel, 1985). Switching the
mode of operation from active to shutdown is a phenomenon that may also be witnessed
regularly in seasonal production facilities. This may result from environmental
conditions or known seasonal fluctuations in demand. No cash flows are generated in
the shutdown mode, but no variable costs are incurred. In this case the possible
shutdown costs as well as costs incurred from restarting operations must be included in
calculations (Kulatilaka and Trigeorgis, 2001). As Dixit and Pindyck (1994) simplify the
issue, the project will be held active at all times when the profit surpasses the flow cost
of operations. This suggests that this type of project ultimately gives an infinite set of
options for function time (McDonald and Siegel, 1985). In some situations temporary
shutdown is simply impossible. If the project requires highly educated staff, and
contracts have to be terminated, the firm might lose the required knowledge, which
However, these implications are only true if we assume a zero-level of shutdown and
restart costs, which is not a very realistic situation. When not in active use, invested
capital is subject to corrosion. Both physical assets, such as machinery and facilities, as
well as intangible assets, such as customer loyalty and brand power fade with time if left
unused or unattended. With physical assets lack of maintenance is an issue, and with the
intangible side customer recollection loses its strength. To evade higher restarting costs
due to the rusting of capital, maintenance procedures can be taken up. This may require
an initial fixed cost in addition to the on-going costs, but may prove to be valuable if it
lowers the cost of activating operations significantly (Dixit and Pindyck, 1994). With
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intangible assets this is considerably harder, as brands need to take part actively in their
consumers’ lives in order to stay relevant.
3.1.4 Option to abandon
If future prospects are seen as highly negative, a firm may consider abandoning the
project to obtain salvage value. Switching costs are also of high relevance here. If the
cost incurred in order to execute the desired abandonment, and acquire salvage value,
reaches the level of the salvage value itself, a firm might be forced to continue
operations even if operations are no longer profitable. By generating cash flow, though
unprofitable, a firm can still cover fixed costs with them, even partially (Kulatilaka and
Trigeorgis, 2001). Permanent abandonment is an extreme choice, as re-entry to the field
will require a whole new investment if facilities are discarded or resold. High costs of
abandonment need to be considered already when the business model is formed, as they
also heighten the entry threshold. A higher price point for the production output must
be obtained to cover the risk of forced abandonment (Dixit and Pindyck, 1994). In some
cases, if assets used in operations are not company-specific, a firm may be able to
exercise the option of abandonment at market price or alternatively only with a
relatively small discount. Liquefying the assets of the project can be carried out by
selling them on the open market to competitors or by putting them to use in another
investment (Keswani and Shackleton, 2006). The effortlessness of the liquidation
process depends on the size of the industry, the uniqueness of the produced output and
the existence of a secondary market for the assets.
The capacity to alter manufacturing facilities to produce different outputs provides a
company with leeway and is forgiving to imperfectly conducted market analysis.
Constant renewal of products is crucial especially in certain industries, such as
technology. Life cycles of these products are shortening constantly, and customers are
becoming increasingly demanding but also willing to update their equipment (Dreyer
and Grønhaug, 2004). Production facilities that are designed to endure technological
updates and modifications help firms to better equip themselves to be able to answer
the constantly altering demand.
3.1.6 Volume flexibility
When there is uncertainty over demand, being able to incrementally increase capacity
shields the company (Dixit and Pindyck, 1994). This relates to the scale economies
theory presented earlier as a limitation to flexibility. Volume flexibility is defined as the
option to produce either above or below the original capacity. This option enables a firm
to adjust to environmental factors affecting the demand of products, as well as adapting
to changes in raw material prices and availability (Dreyer and Grønhaug, 2004). Volume
flexibility differs from the previously presented options of expanding and deferring.
Exercising this option does not require additional costs of switching, but the production
facilities are designed to endure small alterations. The downfall of volume flexible
production is that if demand remains at a stable level, the firm is holding excess
capacity, which is idle during these time periods.
3.1.7 Growth possibilities
New investments can have strong strategic importance, if they serve the firm as test
rounds or experiments in new technology or markets. Taking into account the domino
effect caused by the initial capital outlay may change the course of a project that seemed
unattractive when evaluated separately. If the full potential deriving from the first-stage
investment is not examined and included in calculations, firms may lose significant
opportunities and be unable to sustain competitive advantage (Trigeorgis, 1996).
Though the most difficult to quantify, growth options can turn out to be the most
valuable. The value of being able to create a prototype that has excessive future
potential is an example of such a case (Busby and Pitts, 1995). Investments in R&D
projects can’t be valued as a simple one-time deal; there are several applications of
strategic importance to be examined (Smit and Trigeorgis, 2006).
Generally, if the business environment of a firm is competitive and withholds factors of
uncertainty, flexibility is valuable (Dreyer and Grønhaug, 2004). Using models to value
acquired real options from investment opportunities enables a firm to account for active
project management and interdependencies between various separate projects (Lander
and Pinches, 1998). This is a simple suggestion, and the theory supports logic. When
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environments are more turbulent, these flexible options become more prominent. As
with all investment, there is a time issue also regarding the realisation of these real
options that needs to be taken into account. Evaluating the optimal time to respond to
environmental changes in order to obtain sustainable advantage over competitors is
crucial (Dreyer and Grønhaug, 2004). The development of these alternative methods is
essential for enabling the use of real options and their valuation to become a standard in
capital budgeting practises (Lander and Pinches, 1998). Many different methods have
been examined in order to find the optimal for valuing the benefits derived from
obtaining these flexible real options. Next, we examine some methods that have proved
most relevant and applicable.
3.2.1 Sensitivity analysis
The very basic approach to any uncertain situation is to run a sensitivity analysis. By
examining the probability of the occurrence of each decision point, a firm can see the
vulnerability the project has regarding changes in influencing factors (Lander and
Pinches, 1998). Changing the used hurdle rate or the cash flow forecasts is an
established tool to battle uncertainty in capital budgeting. Using sensitivity analysis or
combining it with different scenarios is the most common approach to evaluating
uncertainty (Chittenden and Derregia, 2013).
3.2.2 Decision trees and influence diagrams
One of the signature features in flexible investments is that they form a sequence of new
possibilities that are only viable after the initial capital outlay, the first project, has been
executed. So, capital budgeting should be able to value these derived opportunities and
also understand the interdependencies between outcomes. Decision trees can achieve
this, and by also simultaneously giving direction for strategy forming. Pitfalls in these
decision-making models are the use of an incorrect discount rate and the complexity
that grows with size. Also, evaluating the probabilities of real events correctly can turn
out to be a challenge (Lander and Pinches, 1998).
Decision problems and their solving rely on the knowledge obtained by the decision
maker. By presenting the structure of the issue at hand and demonstrating the current
knowledge level, influence diagrams attempt to only bring forth the relevant factors of
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the process. Excluding the excess possibilities that are not feasible makes influence
diagrams more concise in comparison to decision trees. However, the appropriate use of
influence diagrams requires uncertainty modelling and probability distributions to be
available (Lander and Pinches, 1998).
3.2.3 Weighted average discount rate (WADR)
This analysis method presented by Feinstein and Lander (2002) provides a valuation
tool for simple real options. The only requirement for the utilisation of the WADR
method is that the discount rate is altered to suit the period where flexibility incurs. This
discount rate is established by comparison to a replica portfolio, which consists of a risk-
free investment and a stake in a rigid project. By computing a weighted average discount
rate for this portfolio, we arrive at the correct flexible discount rate to be used in the
period of flexibility.
This method also only applies to projects where flexibility occurs at one imminent time,
and is later followed by rigidness. The WADR has been identified as an easy stepping
stone, a first level towards the use of more intricate valuation methods for flexibility
programmes. Also, the similarity to traditional NPV computing lowers the threshold for
managers to account for flexibility (Feinstein and Lander, 2002).
3.2.4 Applications to the NPV method
When considering a flexible project with different operation modes, such as capacity or
output, incorporating switching costs of production is crucial. Without these switching
costs the value of a flexible investment can be viewed as the value of a rigid one, added
with the future option values (Kulatilaka and Trigeorgis, 2001). In this case the flexible
project would be the more beneficial choice in all possible scenarios. This is not the case
as switching costs may tilt the scales, if the option to shift production is wrongly timed
or executed. So, we come to this simple suggestion: if the value of the flexible project is
greater than the sum of the rigid NPV and incurred switching costs of option realisation,
the additional investment should be made.
In order to incorporate the needed flexibility factors to the traditional methods used in
capital budgeting, the band of uncertainty on which the future cashflows lay, must be
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established. By utilising this possibility factor, we can use real option theory to value
flexibility. The static NPV describes the known cashflows, and the value of real options
serves as the unpredictable cashflows. Busby and Pitts (1995) present this simple model
Smit and Trigeorgis (2006) also provide an application to the traditional NPV,
incorporating both strategic and flexibility value:
The direct NPV here is the basic approach; cashflows obtained by passive management.
Strategic value stems from competitive interactions; what the firm has gained by cutting
out or outperforming competition. The added value of active project management is
depicted with flexibility value. This outlook is similar to the one presented by Busby and
Pitts, but defines the value of real options further, splitting them to strategic effect and
pure flexibility.
Combinations to and modification of the NPV method bring a sense of familiarity to
managers. These methods also separate the value of the flexible option, making it into a
tangible benefit easier to comprehend and quantify. There are however, some
limitations that might affect the very feasibility of acquiring flexibility in projects, as
discussed in the section below.
Most investments are considered to be irreversible or at least partially irreversible. This
is especially the case in the illiquid investments discussed in this paper, as they are often
real estate or construction work. Due to their nature, these investments need to be
assessed not only by using the traditional NPV, IRR or PB methods, but also by including
in the value of flexible options. In some cases, this type of analysis exposes the
irreversibility of a given project. When investments are considered to be completely
20
solid, flexibility is not given any thought but rather often treated as an expensive safety
net (Feinstein and Lander, 2002). However, in the context of our current environment,
there might not be that many totally solid investments left to be made. Further
examination into obtaining possibilities of future alterations or even deferring should be
a crucial part of capital budgeting (Busby and Pitts, 1995). Next, we examine the
different limitations affecting the integration of flexibility into capital budgeting
practises.
3.3.1 Added
Author Ada Aadeli Title of thesis The requirement for flexibility in capital budgeting Degree Bachelor’s degree Degree programme Accounting Thesis advisor(s) David Derichs Year of approval 2016 Number of pages 33 Language English
Abstract of bachelor’s thesis
3
1.2 PREVIOUS WORKS 8
3. FLEXIBILITY ANALYSIS IN CAPITAL BUDGETING 11
3.1 FORMS OF FLEXIBILITY 11
3.1.1 CHOICE OF TIMING 12
3.1.2 OPTION TO EXPAND OR CONTRACT 13
3.1.3 TEMPORARY SHUTDOWN 14
3.1.5 FLEXIBILITY OF VALUE CHAIN 15
3.1.6 VOLUME FLEXIBILITY 15
3.1.7 GROWTH POSSIBILITIES 16
3.2.1 SENSITIVITY ANALYSIS 17
3.2.3 WEIGHTED AVERAGE DISCOUNT RATE 18
3.2.4 APPLICATIONS TO THE NPV METHOD 18
3.3 CHALLENGES TO FLEXIBILITY 19
3.3.1 ADDED EXPENSES 20
3.3.3 INTEGRATION TO CORPORATE STRATEGY 21
3.3.4 ECONOMIES OF SCALE 21
3.3.5 BALANCING CONTINUITY WITH FLEXIBILITY 21
4. EFFECT OF INTEREST RATE FLUCTUATIONS 22
5. CONCLUSIONS 26
6. REFERENCES 28
7. APPENDIXES 30
1. Introduction
In the current state of our world economy, boosting investments has long been viewed
as an effective fixing method. By encouraging further capital commitments in order to
create more available jobs and overall economic growth, increased investments are a
positive development. Interest rate targeting by central banks is a way for monetary
policy to encourage more investment through affordable loan capital (Roche et. al,
2015). However, at this point in time interest rates are at a record low and the
environment is ever more turbulent. Globalisation and the fast development of
information technology have resulted to shorter product life cycles, constantly changing
consumer preferences and increasingly aggressive competition (Dreyer and Grønhaug,
2004).
Capital budgeting is a key function to evaluate investment profitability. The information
provided by these calculations is then used as a basis for capital outlay decisions. The
most common methods used in capital budgeting by US firms are the net present value
(NPV) and internal rate of return (IRR) methods (Graham and Harvey, 2002). Both of
these use a set hurdle rate, the weighted average cost of capital (WACC) in calculations
and as a comparison to aid decision-making. The WACC is determined by utilising the
risk-free rate, and is thus prone to distortion effects caused by the current zero-bound
level interest rates in place. If we move on to the European markets, where the most
common technique is the payback period (PB) method (Brounen et al. 2004), the
interest rate level comes into play again through the discounted cashflows. The unusual
state of the world economy affects decisions made by accounting departments, causing
distortion due to false market effects (Roche et al. 2015). Traditional methods rely
heavily on the WACC, which can easily be wrongly evaluated. If interest rate levels
elevate unexpectedly, calculations may become invalid. However, as rates are expected
to remain relatively low for some time still, shorter-term capital allocation projects are
less prone to fluctuations in rate levels. Also, short-term cashflows can be forecasted
more reliably. The situation is different in longer-term projects. As the time horizon of a
project grows so does the uncertainty regarding its outcomes. Due especially to these
recent developments, an increased level of flexibility in long-term investments is
5
desirable. To better understand the benefits of flexibility is therefore crucial to sustain
competitive advantage.
This analysis focuses solely on illiquid investments made by private sector actors, such
as production facilities or machinery. To define what is meant by flexibility, it is the
range of options that the investment itself contains. It is not a one-sided concept, as it
entails multiple options. At its simplest, it can be defined as flexibility in the breadth of
capacity, operation level, production outputs, volume and timing (Dixit and Pindyck,
1994; Dreyer and Grønhaug, 2004). In long-term decision-making investments are
vulnerable to changes and it might be desirable to be able to defer investment, alter the
focus or even modify the overall direction or timing of a given project. Investments may
have an abandonment option or possibilities for alteration in e.g. production facilities
(Dixit and Pindyck, 1994). Also, real options, which are new project possibilities
obtained by making the initial investment, are considered as a part of flexibility as they
give room for modifications to the initial investment plan, should conditions change.
Solely pushing for more investments without considering the effects and risks brought
on by a longer time horizon is an ignorant move. It should be kept in mind that
conditions might and will change in the scope of the investment period, as it grows to
several decades. Markets are volatile and forecasting models always imperfect. Interest
rates are traditionally considered to be more stable than revenues, which is why they
are viewed as a constant in calculations, mostly focusing on altering cash flow scenarios
(Alvarez and Koskela, 2006). In the current state of the world, this assumption is no
longer valid in the long run. As a clarification, the cause of current interest rate levels
The factor of uncertainty in investment decisions is often disregarded (Chittenden and
Derregia, 2015). The risk profile of long-term investments is generally higher than that
of the short term, as the determination of cash flow forecasts becomes more difficult
(Cornell, 1999). However, firms usually still only set a single hurdle rate to evaluate all
investments, regardless of the time horizon. A survey in the Nordic countries discovered
that 85,6% per cent of firms responded that their hurdle rates don’t increase with the
time scope of the investment. What is even more alarming is that some even used a
lower rate for the longer term (Brunzell et al. 2013). These implications show that firms
6
are not at the moment fully aware of the requirements brought on by the increased
uncertainty in our investment environment. Practise does not comply with general
financial theory, suggesting that the longer span of future cash flows requires higher
hurdle rates, as they are more uncertain (Mukherjee, 1991).
If we move on to the execution of the actual requirement, flexibility, room for
improvement definitely exists. In order for firms to better maintain their market
positioning and even exist in today’s highly competitive business environment, they
must acquire heightened levels of flexibility. This aids them to weather the movements
of the turbulent environment (Dreyer and Grønhaug, 2004). Valuation of flexibility and
real options obtained is complex, as it includes multiple levels and time horizons.
However, it is now more important than ever for firms to focus their capital assets on
investments with strong potential in order to ensure future success. Often the valuation
models developed in order to count flexibility into calculations are not put to use due to
their complicated and multi-level nature (Smit and Trigeorgis, 2006). This leads to
misevaluation, as the true value of flexibility is not included, further leading to
misevaluations and faulty decision-making in capital budgeting (Feinstein and Lander,
2002).
This thesis aims to pinpoint the need for added flexibility and the reasoning behind it.
Short-sighted, traditional decision-making processes lack the ability to exhaust all
possible options, making them inadequate to fit the current environment. The
motivation behind this paper is to further demonstrate the importance of flexibility
options, the benefits derived from their adoption into capital budgeting and to critically
evaluate the presented methods of valuation. In order to achieve this, the paper will
assess the validity of three key propositions:
1. Capital budgeting methods need to incorporate flexibility in order to correctly
value investment opportunities
2. Flexibility must be established in a versatile manner to shield the firm from
future fluctuations
3. Currently interest rate levels are key external factors calling for greater flexibility
in capital budgeting
7
The following analysis aims to provide insight and prove these propositions right with
1.1 Methods and structure
The analysis has been conducted based on a review of the appropriate literature. To
complete the work and to further present the vast effects of not accounting for
flexibility, a few simple examples using traditional capital budgeting methods by varying
interest rate levels have also been included. As the issue of capital budgeting has been
widely researched in the past, all necessary information can be collected from the right
sample of works. It is not within the scope of this thesis to conduct further research. By
then combining this available theoretical information and previous empirical research
into a comprehensive unity, the value of flexibility can be demonstrated and valuation
methods can be critically assessed. The key terms used in the literature search were
flexibility, real options, flexibility valuation and interest rates, all within the context of
capital budgeting. Using the title and abstract as pruning factors, the sample literature
was chosen from the returned search results. The literature review was conducted by
utilising a Boolean phrase search in Aalto Finna database and Google Scholar. The main
base for the flexibility analysis section was Dixit and Pindyck’s (1994) “Investments
under Uncertainty”. From this book the view on versatile flexibility options and the
limitations they might face was expanded into further material, by identifying key
search terms and utilising the appropriate original sources. Literature on flexibility
measures in capital budgeting can concern both liquid and illiquid investment
opportunities. Some theories and forms however apply to both, in which case they are
presented here only in the context of illiquid investments.
Using a simple model to prove real effects is in itself perhaps obvious, but still necessary.
The capital budgeting methods currently utilised by most private sector actors no longer
capture the true values of investment projects. By making small alterations we can
demonstrate the importance of accounting for flexibility in calculations.
8
Structurally the analysis will start at the very core of capital budgeting; the traditional
methods that have been in place for several decades. Establishing the shortcomings and
oversights of the discounted cash flow methods gives weight to the need for flexibility.
Then moving on to flexibility analysis in capital budgeting practises; looking into the
limitations in place and exploring various forms of flexibility. The assessment of
different valuation methods will take place in the context of these background
influencers presented. Finally, bringing in an external factor, interest rates, will further
demonstrate the imminent requirement for flexibility that is accelerated by the current
economic state of the world. As stated before, the analysis will focus solely on the effects
regarding the increased requirement for flexibility, not to take a stance on what is
causing the current interest rate environment.
1.2 Previous works
Identifying the current status quo in capital budgeting is crucial before conducting new
analysis. Though flexibility is often thought of as a relatively new concept in capital
budgeting, multiple studies and theories have existed for several decades. The valuation
and consideration of real options has been brought forward in addition to the traditional
methods, such as NPV, IRR and PB (e.g. McDonald and Siegel, 1985; Dixit and Pindyck,
1994; Dreyer and Grønhaug, 2004). The effect of certain environmental factors, such as
developments in consumer demand and changes in interest rate levels, has also been
previously connected to capital budgeting (e.g. Dixit and Pindyck, 1994; Kulatilaka and
Trigeorgis, 2001; Alvarez and Koskela, 2006).
Shortcomings of traditional methods have been widely recognised, but for some reason
these realisations have not had a dramatic effect on their popularity (Trigeorgis, 1996;
Feinstein and Lander, 2002; Smit and Trigeorgis, 2006). Regardless of the vast extent of
the conversation regarding flexibility, it’s valuation and inclusion in calculations is still
viewed as somewhat of a special feature rather than a solid standard due to the complex
nature of valuation models (e.g. Lander and Pinches, 1998; Feinstein and Lander, 2002).
With these previous presentations in mind, this thesis will bring theories together in
order to prove the benefits derived from adopting flexible practises into capital
budgeting. These statements made by previous literature will be further assessed and
9
utilised as a backbone for the justification and purpose of this paper. First, we discuss
2. Pitfalls of traditional methods
Traditional methods of capital budgeting don’t succeed in considering all possible
outcomes as the project begins to unravel (Denison, 2009). Leaving flexibility out of the
calculations may cause management to make serious mistakes in capital budgeting and
bypass projects with the highest real potential (Feinstein and Lander, 2002). The use of
simple discounted cash flow (DCF) analysis leaves out the value of waiting and revising
the investment opportunity as uncertain future outcomes are realised (Lander and
Pinches, 1998). Some basic flaws present themselves in the use of DCF methods. Not
acknowledging time as a risk measure and relying too blindly on a set hurdle rate leave
investments vulnerable to unfavourable environmental changes. Also, by assuming a
constant capital structure and passive management these methods undermine the role
of managers and their reaction capabilities. Most importantly, growth possibilities,
which are significant sources of competitive advantage, are often overlooked with
traditional methods. Next, these underlying weaknesses of traditional capital budgeting
methods are examined.
Disregarding duration
As the time horizon of an investment grows, the predictability of future cashflows
diminishes. This effect has even more relevance in today’s volatile markets (Smit and
Trigeorgis, 2006). Regarding especially long-term investment projects, the net present
value method overlooks the importance and effect of duration. As the time span grows,
interest rate volatility in the long run becomes relevant. This issue causes the hurdle
rate of initial calculations to be incorrect regarding the later years of project life
(Trigeorgis, 1996).
Assumption of passive management
The simple NPV approach also assumes for management to continue their passive
approach on investments even when circumstances alter (Keswani and Shackleton,
2006). As the initial capital outlay has been made, NPV does not consider the possibility
10
of alterations, the use of real options, which will be discussed in detail later when
moving on to the flexibility analysis. These modifications can be e.g. abandonment,
capacity or output changes (Dreyer and Grønhaug, 2004). The assumption of this static
Rigid hurdle rate
Though cashflows might be modified to project dynamic decision-making by
management, the faulty in the NPV method often stems from the rigid use of the
discount rate, the WACC. Flexible design of a project enables it to obtain a lower hurdle
rate since it can better be modified to respond to changes in uncertain factors (Lander
and Feinstein, 2002). These possibilities are overlooked, and the discount rate is not
adjusted accordingly.
Assumption of a constant capital structure
Another pitfall of the traditional methods utilising the set hurdle rate, WACC, in
valuation is that the assumption of a constantly remaining capital structure in a longer
project is highly unrealistic. Firms will shift their relation of debt and equity according
to market movements and affordability (Graham and Harvey, 2002).
Overlooking growth opportunities and competitive advantage indicators
What brings the most dramatic difference between traditional, rigid methods of capital
budgeting and the flexible take of real options, are projects with initial negative net
present values. These projects, though seemingly unattractive, might turn out to be in a
key position for unlocking future growth potential (Trigeorgis, 1996). Overall, as
consumer demands are persistently changing, and at an accelerating pace, maintaining
competitive advantages is even more crucial. For a firm to remain at the top, it must be
able to satisfy these altering needs by providing better services. NPV and other
traditional methods overlook such indicators in projects, like quality enhancement and
response time (Aggarwal et. al, 1991). These are hard to directly quantify and may not
On a more general note, traditional methods are also using the same set WACC for all
projects, thus assuming that the risk level of all projects is similar to the firm’s as a
11
whole (Trigeorgis, 1996). Investment opportunities should be valuated uniquely, as
heavy dispersion among projects may exist. A very basic obstacle in traditional capital
budgeting is that the conversion of all benefits derived and costs incurred, generated
cashflows and intangible effects can be simply impossible. Quantifying effects such as
increased brand power or positive firm image and then incorporating them into simple
NPV calculations is not feasible. Also, traditional methods are seen to be best suited for
environments with low levels of uncertainty and risk; this does not exactly correspond
Everything discussed above gives weight to the increased requirement for flexibility in
capital budgeting. New valuation methods for projects can provide more reliable
knowledge, lead a firm to the optimal decision and solve some of the issues faced by
3. Flexibility analysis in capital budgeting
As the very concept of flexibility is harder to comprehend than simple NPV analysis
based on discounted cash flows, flexibility needs to first be defined. When the benefits
and content of flexibility have been identified, the value of these flexibility options needs
to be estimated and quantified. Lastly, some basic limitations apply to the use and
Flexibility as a concept entails many different implications. It can be seen as an option to
choose the timing of each investment freely (Kort et. al, 2010), or as the possibility of
alterations as future circumstances begin to realise (Kulatilaka and Trigeorgis, 2001).
Flexibility can be viewed as company-specific; a resource specialised in the adjustment
and full exploitation of a single actor’s opportunities (Dreyer and Grønhaug, 2001).
Before we arrived at one simple definition by combining alternate sources: flexibility
can be defined as ‘wiggle room’ in the breadth of capacity, operation level, production
12
outputs, volume and timing (Dixit and Pindyck, 1994; Dreyer and Grønhaug, 2004). Due
to recent developments in the overall investment environment, flexibility has
experienced a rise in popularity and is now viewed as a way to obtain competitive
advantages over rival companies. Some forms of flexibility can also be area- or industry-
specific, or simply not as important in all fields of business (Dreyer and Grønhaug,
2004). In some fields investing in flexibility might not even be worthwhile. These are
industries with low uncertainty in operations and demand (Kulatilaka and Trigeorgis,
2001). However, the current economic environment has vast effects and touches upon
all industries. It is crucial to not only understand but also value these flexible options
correctly and seize the possibilities they bring in order to maintain competitiveness of
the firm.
These options can either occur naturally or require additional capital outlay (Baldwin
and Clark, 1992). It is crucial for firms to have high-quality knowledge on their
respective operating markets. Evaluating whether to invest in a more expensive but
flexible investment rather than the rigid one with lower initial cost is a fundamental skill
in competitive industries (Feinstein and Lander, 2002). Now, we examine the different
realisations of flexible options in investments presented in different publications. Some
of these forms have been recognised as general flexibility in operations, but as we focus
on illiquid investments, such as manufacturing facilities, the same options and their
3.1.1 Choice of timing
In most investment decisions, timing is crucial. Finding the correct position for new
market entry or construction might make or break a project. Even if a project already
shows positive NPV, it might be more profitable to wait for better conditions or new
available information regarding the market (Kulatilaka and Trigeorgis, 2001). Another
implication of timing derives from the competitive forces at play; early investment and
the risk it bears might be optimal if there is danger of otherwise losing the opportunity
to a competitor (Smit and Trigeorgis, 2006).
The option to defer investment to a later time is indeed a key form of flexibility, though
not always a possibility. Strategic focus or aggressive competition might force a
13
company to make quick investment decisions (Dixit and Pindyck, 1994). Generally the
first investor, a pioneer in a sense, collects the largest financial compensation among the
rival group when strategic effects of investing exist. However, when uncertainty levels
are high, early commitment might not be the best option regarding future outcomes. If a
spill-over effect regarding information exists in the field, it might be more beneficial to
be a follower rather than the leader (Chevalier-Roignant et al., 2011). In these situations
second-to-entry firms might actually find cost benefits from lower need for consumer
analysis or R&D projects.
Deferring investment is however, usually achievable. It may incur some added costs,
which include the risk of other market entrants and lost possibilities, but as previously
stated, new market information can be worth the wait. Being able to wait for the
investment opportunity’s true potential to be revealed can salvage the company from
making rash decisions that can turn out to be costly (Dixit and Pindyck, 1994). What
most commonly incentives firms to exercise the possibility of deferring investment are
uncertainty over demand or interest rates and the lack of sufficient internal capital
(Chittenden and Derregia, 2013). The value of waiting is generally higher when interest
rate uncertainty is high and the overall duration of the project is long (Trigeorgis, 1996).
This indication applies perfectly to the capital budgeting decisions discussed within this
paper.
3.1.2 Option to expand or contract operations
When the investment has already been carried out, and operations are functioning at the
initial intended capacity, companies examine the realisation of their projected demand.
If they find that demand is higher than expected, they might consider investing in
further capacity to satisfy this demand. On the contrary, if demand is lower than
projected at initiation, a firm may choose to contract operations in order to save on
variable costs (Kulatilaka and Trigeorgis, 2001). Expanding operations is a partially
irreversible investment; it requires further capital outlay on e.g. manufacturing
hardware. Contracting can however be reversed without significant cost, if it is executed
by leaving facilities idle and not by selling equipment.
14
Adding capacity usually has the initial effect of increasing profit margins, as fixed costs
remain the same but there are more units to cover the incurred costs. Eventually the
leap to larger fixed costs must be made and often the situation of diminished returns
comes into play (Dixit and Pindyck, 1994). So, the alterations in demand should be
considered somewhat permanent in order to justify irreversible expanding of
operations.
3.1.3 Temporary shutdown
The basic idea behind a temporary shutdown is simple; as derived revenues are less
than variable costs, operations should be seized. This option however is rarely examined
in the initial process of capital budgeting (McDonald and Siegel, 1985). Switching the
mode of operation from active to shutdown is a phenomenon that may also be witnessed
regularly in seasonal production facilities. This may result from environmental
conditions or known seasonal fluctuations in demand. No cash flows are generated in
the shutdown mode, but no variable costs are incurred. In this case the possible
shutdown costs as well as costs incurred from restarting operations must be included in
calculations (Kulatilaka and Trigeorgis, 2001). As Dixit and Pindyck (1994) simplify the
issue, the project will be held active at all times when the profit surpasses the flow cost
of operations. This suggests that this type of project ultimately gives an infinite set of
options for function time (McDonald and Siegel, 1985). In some situations temporary
shutdown is simply impossible. If the project requires highly educated staff, and
contracts have to be terminated, the firm might lose the required knowledge, which
However, these implications are only true if we assume a zero-level of shutdown and
restart costs, which is not a very realistic situation. When not in active use, invested
capital is subject to corrosion. Both physical assets, such as machinery and facilities, as
well as intangible assets, such as customer loyalty and brand power fade with time if left
unused or unattended. With physical assets lack of maintenance is an issue, and with the
intangible side customer recollection loses its strength. To evade higher restarting costs
due to the rusting of capital, maintenance procedures can be taken up. This may require
an initial fixed cost in addition to the on-going costs, but may prove to be valuable if it
lowers the cost of activating operations significantly (Dixit and Pindyck, 1994). With
15
intangible assets this is considerably harder, as brands need to take part actively in their
consumers’ lives in order to stay relevant.
3.1.4 Option to abandon
If future prospects are seen as highly negative, a firm may consider abandoning the
project to obtain salvage value. Switching costs are also of high relevance here. If the
cost incurred in order to execute the desired abandonment, and acquire salvage value,
reaches the level of the salvage value itself, a firm might be forced to continue
operations even if operations are no longer profitable. By generating cash flow, though
unprofitable, a firm can still cover fixed costs with them, even partially (Kulatilaka and
Trigeorgis, 2001). Permanent abandonment is an extreme choice, as re-entry to the field
will require a whole new investment if facilities are discarded or resold. High costs of
abandonment need to be considered already when the business model is formed, as they
also heighten the entry threshold. A higher price point for the production output must
be obtained to cover the risk of forced abandonment (Dixit and Pindyck, 1994). In some
cases, if assets used in operations are not company-specific, a firm may be able to
exercise the option of abandonment at market price or alternatively only with a
relatively small discount. Liquefying the assets of the project can be carried out by
selling them on the open market to competitors or by putting them to use in another
investment (Keswani and Shackleton, 2006). The effortlessness of the liquidation
process depends on the size of the industry, the uniqueness of the produced output and
the existence of a secondary market for the assets.
The capacity to alter manufacturing facilities to produce different outputs provides a
company with leeway and is forgiving to imperfectly conducted market analysis.
Constant renewal of products is crucial especially in certain industries, such as
technology. Life cycles of these products are shortening constantly, and customers are
becoming increasingly demanding but also willing to update their equipment (Dreyer
and Grønhaug, 2004). Production facilities that are designed to endure technological
updates and modifications help firms to better equip themselves to be able to answer
the constantly altering demand.
3.1.6 Volume flexibility
When there is uncertainty over demand, being able to incrementally increase capacity
shields the company (Dixit and Pindyck, 1994). This relates to the scale economies
theory presented earlier as a limitation to flexibility. Volume flexibility is defined as the
option to produce either above or below the original capacity. This option enables a firm
to adjust to environmental factors affecting the demand of products, as well as adapting
to changes in raw material prices and availability (Dreyer and Grønhaug, 2004). Volume
flexibility differs from the previously presented options of expanding and deferring.
Exercising this option does not require additional costs of switching, but the production
facilities are designed to endure small alterations. The downfall of volume flexible
production is that if demand remains at a stable level, the firm is holding excess
capacity, which is idle during these time periods.
3.1.7 Growth possibilities
New investments can have strong strategic importance, if they serve the firm as test
rounds or experiments in new technology or markets. Taking into account the domino
effect caused by the initial capital outlay may change the course of a project that seemed
unattractive when evaluated separately. If the full potential deriving from the first-stage
investment is not examined and included in calculations, firms may lose significant
opportunities and be unable to sustain competitive advantage (Trigeorgis, 1996).
Though the most difficult to quantify, growth options can turn out to be the most
valuable. The value of being able to create a prototype that has excessive future
potential is an example of such a case (Busby and Pitts, 1995). Investments in R&D
projects can’t be valued as a simple one-time deal; there are several applications of
strategic importance to be examined (Smit and Trigeorgis, 2006).
Generally, if the business environment of a firm is competitive and withholds factors of
uncertainty, flexibility is valuable (Dreyer and Grønhaug, 2004). Using models to value
acquired real options from investment opportunities enables a firm to account for active
project management and interdependencies between various separate projects (Lander
and Pinches, 1998). This is a simple suggestion, and the theory supports logic. When
17
environments are more turbulent, these flexible options become more prominent. As
with all investment, there is a time issue also regarding the realisation of these real
options that needs to be taken into account. Evaluating the optimal time to respond to
environmental changes in order to obtain sustainable advantage over competitors is
crucial (Dreyer and Grønhaug, 2004). The development of these alternative methods is
essential for enabling the use of real options and their valuation to become a standard in
capital budgeting practises (Lander and Pinches, 1998). Many different methods have
been examined in order to find the optimal for valuing the benefits derived from
obtaining these flexible real options. Next, we examine some methods that have proved
most relevant and applicable.
3.2.1 Sensitivity analysis
The very basic approach to any uncertain situation is to run a sensitivity analysis. By
examining the probability of the occurrence of each decision point, a firm can see the
vulnerability the project has regarding changes in influencing factors (Lander and
Pinches, 1998). Changing the used hurdle rate or the cash flow forecasts is an
established tool to battle uncertainty in capital budgeting. Using sensitivity analysis or
combining it with different scenarios is the most common approach to evaluating
uncertainty (Chittenden and Derregia, 2013).
3.2.2 Decision trees and influence diagrams
One of the signature features in flexible investments is that they form a sequence of new
possibilities that are only viable after the initial capital outlay, the first project, has been
executed. So, capital budgeting should be able to value these derived opportunities and
also understand the interdependencies between outcomes. Decision trees can achieve
this, and by also simultaneously giving direction for strategy forming. Pitfalls in these
decision-making models are the use of an incorrect discount rate and the complexity
that grows with size. Also, evaluating the probabilities of real events correctly can turn
out to be a challenge (Lander and Pinches, 1998).
Decision problems and their solving rely on the knowledge obtained by the decision
maker. By presenting the structure of the issue at hand and demonstrating the current
knowledge level, influence diagrams attempt to only bring forth the relevant factors of
18
the process. Excluding the excess possibilities that are not feasible makes influence
diagrams more concise in comparison to decision trees. However, the appropriate use of
influence diagrams requires uncertainty modelling and probability distributions to be
available (Lander and Pinches, 1998).
3.2.3 Weighted average discount rate (WADR)
This analysis method presented by Feinstein and Lander (2002) provides a valuation
tool for simple real options. The only requirement for the utilisation of the WADR
method is that the discount rate is altered to suit the period where flexibility incurs. This
discount rate is established by comparison to a replica portfolio, which consists of a risk-
free investment and a stake in a rigid project. By computing a weighted average discount
rate for this portfolio, we arrive at the correct flexible discount rate to be used in the
period of flexibility.
This method also only applies to projects where flexibility occurs at one imminent time,
and is later followed by rigidness. The WADR has been identified as an easy stepping
stone, a first level towards the use of more intricate valuation methods for flexibility
programmes. Also, the similarity to traditional NPV computing lowers the threshold for
managers to account for flexibility (Feinstein and Lander, 2002).
3.2.4 Applications to the NPV method
When considering a flexible project with different operation modes, such as capacity or
output, incorporating switching costs of production is crucial. Without these switching
costs the value of a flexible investment can be viewed as the value of a rigid one, added
with the future option values (Kulatilaka and Trigeorgis, 2001). In this case the flexible
project would be the more beneficial choice in all possible scenarios. This is not the case
as switching costs may tilt the scales, if the option to shift production is wrongly timed
or executed. So, we come to this simple suggestion: if the value of the flexible project is
greater than the sum of the rigid NPV and incurred switching costs of option realisation,
the additional investment should be made.
In order to incorporate the needed flexibility factors to the traditional methods used in
capital budgeting, the band of uncertainty on which the future cashflows lay, must be
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established. By utilising this possibility factor, we can use real option theory to value
flexibility. The static NPV describes the known cashflows, and the value of real options
serves as the unpredictable cashflows. Busby and Pitts (1995) present this simple model
Smit and Trigeorgis (2006) also provide an application to the traditional NPV,
incorporating both strategic and flexibility value:
The direct NPV here is the basic approach; cashflows obtained by passive management.
Strategic value stems from competitive interactions; what the firm has gained by cutting
out or outperforming competition. The added value of active project management is
depicted with flexibility value. This outlook is similar to the one presented by Busby and
Pitts, but defines the value of real options further, splitting them to strategic effect and
pure flexibility.
Combinations to and modification of the NPV method bring a sense of familiarity to
managers. These methods also separate the value of the flexible option, making it into a
tangible benefit easier to comprehend and quantify. There are however, some
limitations that might affect the very feasibility of acquiring flexibility in projects, as
discussed in the section below.
Most investments are considered to be irreversible or at least partially irreversible. This
is especially the case in the illiquid investments discussed in this paper, as they are often
real estate or construction work. Due to their nature, these investments need to be
assessed not only by using the traditional NPV, IRR or PB methods, but also by including
in the value of flexible options. In some cases, this type of analysis exposes the
irreversibility of a given project. When investments are considered to be completely
20
solid, flexibility is not given any thought but rather often treated as an expensive safety
net (Feinstein and Lander, 2002). However, in the context of our current environment,
there might not be that many totally solid investments left to be made. Further
examination into obtaining possibilities of future alterations or even deferring should be
a crucial part of capital budgeting (Busby and Pitts, 1995). Next, we examine the
different limitations affecting the integration of flexibility into capital budgeting
practises.
3.3.1 Added